China: Pausing for a breather

Economic growth in 2003 was well above trend despite the attack of SARS, driven by rapid investment growth. With real GDP growth at 9.1%, many fear that the economy is overheating. As we have argued previously, China is facing an over-investment problem, rather than overheating in the broad economy. In fact, private consumption and exports still have room to grow before excess demand appears.

We expect China to slow moderately with GDP growth falling from 9.7% in the first half to 8% in the second half of 2004. Growth should then stabilize in 2005. The current slowdown in the economy would prepare China for another episode of rapid growth between 2006 and 2008. An investment and private consumption boom could emerge on the back of the 'feel-good' factor stemming from the Beijing Olympics in 2008 and the World Expo in Shanghai in 2010.

From euphoria to sensibility
Data in recent months suggest China is currently on the right track towards a managed slowdown in investment and in the monetary base. While there are concerns over whether such a slowdown could go too far in the next 12-18 months, foreign investors continue to cast their votes of confidence on China's longer term prospects as a production base and a consumer market. General Motors plans to spend $3bn in the next three years to expand its existing production capacity in China. Bayer Group is also planning to invest $1.8bn in China between 2004 and 2006. The amount represents almost half of the company's overseas investment budget. Tesco is buying a 50% stake in a local chain for $260mn. All this is indicative of the longer-term upward trend.

Contracted foreign direct investment (FDI) to utilised FDI can be used as a proxy for foreign investor sentiment. The rise or fall in the ratio indicates whether foreign investors are committing more capital to China, a reflection of investor sentiment. This ratio has been rising since 2003 with contracted FDI currently more than twice as much as actual FDI. Although the ratio seems to be topping out, partly due to the macroeconomic measures, it is still above trend. Foreign investors are no longer treating China as just a cheap manufacturing hub, but also a potentially huge consumer market and a growing pool of talent.

Heated debate over the cooling economy has encouraged both domestic and overseas investors to realign their China strategies more realistically. China is after all not exempt from the global economic cycle. Although headline growth may appear stable between 7% and 9%, various components of the economy are subjected to much greater volatility.

Rising FDI and slower investment can be compatible
Rising foreign direct investment flows at a time when the government is trying to decelerate fixed asset investment is not mutually exclusive. Firstly, FDI is only a small proportion of total investment in China. In 2003, FDI was only 8% of fixed asset investment. China is not short of capital. Yet the focus is on attracting the foreign technology, management skills and other operational know-how to improve competitiveness and productivity. Therefore the government will be happy to see the steady inflow of foreign capital.

Secondly, the Chinese authority is trying to weed out uncompetitive, low quality and duplicate investment. Broadly speaking, foreign projects are seen as higher quality as their feasibility is assessed through potential return and financial profit. The government's attempts to slow investment typically targets local, small and medium domestic enterprises that are involved in over-invested sectors. Some of these are heavily speculative; management have little to no expertise in the business, attracted simply because the industry is in vogue or seen as the 'next big thing'.

Thirdly, the government is not attempting to halt all investment, but merely guiding it to a more sustainable level. It is employing more market-oriented measures, such as raising capital requirements and requesting banks to be more prudent when approving new loans. These policies aim to reduce dependency on bank loans and pressure investors into becoming more responsible for their decisions. Ultimately, the government will continue to encourage projects as long as they are commercially viable. In this case, many foreign investors will qualify.

Policies to promote private enterprise and investment announced on July 26 by the State Development and Reform Commission was very much in line with widening the role of market forces in the economy. In theory, it makes investment easier for private enterprises are reducing the amount of government approvals required, based on the assumption that investment decisions will be made under market conditions.

PBOC facing a game of patience
For the Chinese government, the cards they have revealed so far are favourable. Money supply growth, fixed asset investment and bank lending numbers have all peaked, although they have yet to reach their respective sustainable levels. These indicators should persuade the government and the central bank to observe longer before applying more tightening pressures.

Despite the occasional hawkishness from the People's Bank of China (PBOC), they still seem uncomfortable with higher rates. After all, raising benchmark interest rates, such as the one-year working capital lending rate, could hurt the economy more than just containing inflation or investment. This view was reiterated by, Guo Shuqing, deputy governor of the central bank, suggesting the PBOC will need to act prudently.

The biggest concern is the effectiveness of monetary policy in China. The recent surge in inflation was caused by the rise in food prices, and higher interest rates are unlikely to ease such shortages in food. Shortage of land and labour has been a key factor behind the demand/supply imbalance of foodstuffs.

For investment, the cost of borrowing plays a smaller role in the investment decision process compared with the West. Thus investment growth will be less sensitive to changes in interest rates and only aggressive tightening measures would induce the desired effect. Yet such aggressive measures will also have the negative side effect of dampening the rest of the economy, such as private consumption. Other natural constraints to growth are already emerging. Power shortages are increasingly disrupting production. Some tourist hotspots, such as the Bund in Shanghai, have lost some of their allure due to this summer's energy conservation drive.

Bank lending and monetary growth should be more responsive to higher interest rates but, given the risks highlighted above, it is questionable whether raising benchmark lending rates is the best solution. Giving commercial banks more flexibility in setting lending rates in accordance to customers' risk profile could be a more effective measure as well as being in line with the liberalisation of the banking sector. This alternative will also ease the shortage of capital in under-invested sectors such as energy, agriculture and selected infrastructure. This is also consistent with the 'differentiated approach' recommended by the banking regulator.

From the financial market's perspective, the central bank will need to proceed with caution. It must remain mindful of the interest rate differential between the US and China and the impact on the CNY's revaluation pressure. Hence it would be reluctant to raise domestic rates more aggressively than the US.

Higher rates could also set back banking reform
Furthermore, the PBOC is also watching the reaction from local equity and bond markets. The adverse impact on stocks and bonds from expectations of higher interest rates represents a serious threat to the financial strength of state-owned enterprises and financial institutions, as many hold substantial portfolios of government bonds and/or other financial assets. Managing market expectations would be critical to avoiding significant volatility.

Already, the slowing economy will pressure some businesses that are on life support. The risk of default amongst these weaker companies will likely rise. The Big Four state-owned commercial banks have reduced their non-performing loan ratio by 4.8 percentage points between the end of 2003 and mid 2004. But further improvement will be increasingly difficult without the injection of fresh capital from the authorities. Higher debt servicing costs, approximately 14bn yuan per month for each percentage point increase in the lending rate, could exacerbate the situation further.

Benchmark rate to stay put in 2004
In sum, the central bank is facing a policy dilemma where it is uncertain about the effectiveness of rate hikes, yet the adverse impact on financial markets is already apparent. The good news is that the latest release of softening economic data is reducing central bank urgency to tighten monetary policy. Hence various administrative measures, such as requesting greater bank prudence in new lending, restrictions on new investment or projects and capital requirement, are expected to remain as primary tools to guide the economy to a more sustainable growth rate. Despite upside risks to interest rates, the PBOC is not expected to raise benchmark rates in 2004. Moreover, the central bank will be careful not to tighten other monetary levers, such as reserve requirements, too aggressively.